Founder Beware- How a quick perusal of a Term Sheet can be an effective predictor of a VC’s relation

A Term Sheet is like a first date with your VC, and often clearly reveals the ideology that differentiates the more ego-centric funds from those interested in simultaneously building a great partnership by investing their time and connections (as well as their LPs’ dollars), while recognizing the importance of protecting a founder’s interests. Without content founders who feel appreciated, the goal of creating a great company that will benefit all concerned will likely not be attained. The ambition and motivation of a founder who is resentful and feels hijacked by its investor will drastically decline, and the success of the company will likely be a direct casualty.

A few key Term Sheet provisions which deserve extra attention:

1.Full-ratchet anti-dilution provisions – Full ratchet is the most beneficial form of anti-dilution protection for the VCs and investors who receive it. When a down round occurs (a financing at a lower valuation than prior rounds), full ratchet investors have the ability to convert their preferred stock to common stock at the new price which substantially increases the number of shares they own, but leaves their ownership percentage of the business intact. Dilution still occurs, but it is borne solely by company founders and common stock shareholders.

2. Liquidation Preference multiples and uncapped participation rights – The liquidation preference determines how the pie is shared on a liquidity event (exits and dissolutions). There are two components involved: (a)the actual preference (amount invested in a round returned to a series ahead of other series of stock), which may provide for a multiple of such investment (ranging from 1x to 10x on the original investment); and (b) participation in proceeds following recovery of the preference. In greedier scenarios, participation rights may be uncapped (aka double-dipping, in the presence of a multiple on the preference). Remember that most professional, reasonable investors will not want to gouge a company with excessive liquidation preferences, as the greater the liquidation preference ahead of management and employees, the lower the potential value of the management / employee equity. It is a fine balance, and the rational investor will try and reach a happy medium between “the best price” and ensuring “maximum motivation” of management and employees.

3. Restrictive Provisions – Many a VC has been shortsighted enough to be overtaken by control freakishness, and included an oppressive laundry list of company actions on which it is guaranteed a veto. In doing so, it grossly inhibits its portfolio company’s ability to operate autonomously without the VC’s frequent involvement in its finances, and treats it like an unruly teenager. Again, a fine balance needs to be struck between protecting your autonomy, while ensuring that the VC feels that its investment is being prudently protected. A company should vigorously resist overly restrictive provisions, and urge investors to trust the board of directors to make the right decisions.

4. Redemption Rights – Redemption rights allow investors to force the company to buy back its stock sometime in the future, to ensure some liquidity from the company if it does not perform well. Requiring redemption rights can also be interpreted by founders as a clear indication of the VC’s lack of commitment to the company, and as a non-confidence vote. Redemption rights are often a thorn in a company’s side which may be difficult to remove down the road. Redemption rights may make it more difficult for the company to raise future rounds of capital, as latter round investors may be concerned that their investment funds may be used to buy out the earlier investors rather than growing the company. Additionally, later investors will likely demand redemption rights if the first round investors have them. In attempting to avoid granting redemption rights, it should be pointed out that the board of directors will protect the liquidity rights of all shareholders, and if a company has no money, a redemption right has very little value anyways. If granting a redemption right is unavoidable, postpone the redemption date as far as possible into the future, and spread out the payment for a redemption right over a few years in order to protect the company’s cash flow. As for redemption price, while the VC will usually want the stock redeemed at its liquidation price plus any accumulated and unpaid dividends, if the purpose of redemption is to provide liquidity, then the redemption price should be the fair market value of the stock at the time of redemption, and if the parties cannot agree on what price is fair market value, a third party appraisal will do the trick.

So pay close attention to the fine print before you make the deal, to ensure that the relationship has staying power

#founder #startup #termsheet #VCs